Speed read

Core issue is structural weakness, though weaker yen would be positive

The Japanese central bank announced the novel measures in late September after years of quantitative easing and the earlier introduction of negative savings rates largely failed to generate growth. It set a target of zero for 10-year government bond yields to offset the impact of negative rates on Japanese banks, along with a plan to overshoot its inflation target of 2%.

“Yield curve control is a cool plan, but unfortunately it is no solution for the underlying problems that have bedeviled the Japanese economy for years,” says Daalder, Chief Investment Officer of Robeco Investment Solutions.

“More fundamental is the question of what has actually been changed by the latest twist. We do not think that the ‘we-will-overshoot-2%’ is a game changer with respect to future inflation, while the yield curve targeting – although technically different – does not represent a direct inflationary impulse either. So at the current depressed levels, we don’t believe that lower rates or bond yields still have the ability to stimulate the economy.”

Daalder says there are at least five reasons why lower yields and interest rates may either not work, or actually backfire:

Signal function. Theoretically, lower rates and yields lower the financing costs for firms, potentially triggering them to start investing more. In recent years however, interest rates appear to have acted as a signal for a weakening economy instead.

Impact on pensions. In an aging society, with many people hoping to retire in the near term, lower bond yields are likely to lead to higher, not lower savings. More savings leads to less consumption and lower GDP growth.

Move to cash. Negative yields and rates push people towards paper money, which means the central bank is losing grip on the money supply.

Distortion of economic processes. With yield curve targeting, the pricing mechanism is being shut down, which can lead to all kinds of distortions. Investors may start to take on too much risk (in search of yield), and the incentive for debt to accumulate stays in place.

Negative impact on banks. The move to negative rates raised a lot of concerns about the profitability of banks. And the largest scope of yield curve widening is now pushed out to the longer-dated part of the curve, which could raise volatility.

Japan badly needs inflation

Regarding plans to overshoot the 2% inflation target, Daalder advises investors not to hold their breath. “Looking at the track record, inflation may have temporarily been boosted above 2% back in 2014, but this was solely a result of the consumption tax increase administered back then: underlying inflation has never managed to reach the target,” he says.

“In fact, despite the very aggressive QE programs introduced since then, core and headline inflation have once again moved towards deflation territory in recent months. Having structurally missed the target for more than three years (in fact, for over 20 years already), it sounds a bit strange that you then raise that target.”

‘The BoJ apparently is hoping to change something in the underlying structure’

“The reason for this change appears to be rather academic: having studied why inflation has failed to pick up despite the huge monetary stimulus, the researchers of the BoJ concluded that this was mainly due to too-low and stable inflation expectations. By explicitly lifting the 2% target, the BoJ apparently is hoping to change something in the underlying structure.”

“Whether companies and households will be very impressed by this change in policy, after having been confronted with low-to-no inflation for over 20 years, is something you can seriously question. Higher inflation expectations come with higher inflation, not because a central bank is raising its target.”

Lost cause? Japanese inflation has rarely exceeded the 2% target. Source: Robeco, Bloomberg

Structural problems remain

Daalder says the ‘elephant in the room’ is this core problem of structural impediments that led to Japan’s ‘lost decade’ of the 1990s. Japan was an export-led economy that was overtaken by China, while immigration – widely viewed as an essential force to raise GDP as domestic society ages – is extremely low. Lower spending by fewer people led to deflation and a recession, from which Japan has never fully recovered.

“The Japanese government has been trying to stimulate the economy back to its former glory for two decades already, without much success,” he says. “Adopting a yield curve target is not a magic wand that will make government spending all of a sudden more effective.”

‘It certainly is not a game changer with respect to the overall policy mix’

“Which leaves one important variable open: the one-trick pony that the whole strategy of Abenomics continues to be leaning on – a weaker yen. Whether or not this new twist in monetary policy will successfully break the trend of the steady strengthening of the yen remains to be seen.”

“All in all, although it is an elegant move, it certainly is not a game changer with respect to the overall policy mix. Structural reforms, higher wages and – preferably – a weaker yen are the best ways forward for Japan.”

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